No. of Recommendations: 25
The return of an equal-weight index like the RSP, over the long-term, is almost certain to be better than the cap-weighted equivalent like the S&P500.
Why? Serious question.
Academics will tell us it's because RSP gets, a little bit, to the small and value factors. If that's the case, why not target small and value factors?
No, it's not the small/value factor tilt. Not based on my research.
There is a small amount that is a result of pumping a bit (very small bit) of money out of statistical noise in prices: some prices bump up a bit in one period while others go down a bit. The next rebalance will sell tiny bits of the first group and buy tiny bits of the second group. In the next period, like as not, the same random noise will be in the reverse direction. This creates a bit of value, but it is small. it's fairly easy to manage by simulating rebalancing at faster and faster intervals, and see where it tops out. You might get 0.2% that way if you type really quickly and don't pay commissions.
Rather, the main source of value is from not holding large amounts of things that are currently overvalued, a disadvantage of any cap-weight index (whole market, sector, whatever).
Consider: Let's assume that every company has some true intrinsic value. Its value is unknowable by mere humans, but it exists: the present value of all future coupons it can eventually pay out, till the end of the universe (or bankruptcy), counting any final payout at shutdown or acquisition. Since this number is unknown, at any given time we assume that some stocks are trading above their true intrinsic value, and some are trading below true intrinsic value. If they were all trading at true fair value, then cap weight order would be the same as "total aggregate company value" order. But because some are a bit overvalued and some a bit undervalued on any given day, that order gets slightly shuffled. Each company is going to be at least a few notches higher or lower in the sort order than it "should" be based on: the ranks will have error bars. With me so far?
There are two things that are important that come out of this.
First, it means that on any given day, you have more of your money allocated to the overvalued firms, and less of your money allocated to the undervalued firms. This is not optimal. In the simplest sense, this is the reason cap weight is so bad.
Second, the order shuffling does weird things at the very top. Overvalued stocks near the very top shuffle to the top, and there aren't any higher valued firms to shuffle downwards into the ranks to balance that out. Consequently it is inevitable that, on average, the very largest firms are very much more than "randomly" likely to be overvalued ones...and those are the ones to which a cap-weight strategy allocates the most money.
It's certainly true that the very largest firms have been outstanding performers lately, but one has to realize that for the prior few centuries this was very much NOT the case on average...for the reasons above. (and also because times change...the very most successful firms were once railroads, but that's not true any more). For example, the biggest 5 stocks underperformed the S&P 500 by a bout 4.25% per year in the 30 year 1986-2015 inclusive. Then the Magnificent group bull run started: the biggest 5 led the index by 9%/year in the next 9 years. My hunch is that this won't be the case forever. (This is actually the same as the first effect, but because the position sizes are so large it becomes really important).
An excellent article to track down is "The Surprising Alpha From Malkiel's Monkey and Upside-Down Strategies". It's a test of all the "smart alpha" strategies which weight stocks within broad portfolios in ways other than by market cap. They also tested the *reverse* of every strategy: e.g., heavily weighting the very worst firms ranked by ROE, not just the test of overweighting the very best. The prosaic but strong result was that virtually every "smart alpha" strategy beat the S&P 500. The more startling result: so did virtually every reversed strategy. The main conclusion was that capitalization weighting is a singular outlier...to the down side. Any other weighting (at least from the long list that they used, or their inverses) worked better. Equal weight is one of the simplest non-cap strategies, and minimizes company specific risk.
You can find that paper on line by searching the title. The main page about it at Research Affiliates has a broken link, but it's out there.
The authors of that white paper attributed the outperformance to the "factor" stuff, but I think that's nonsense based on my own analysis, and the fact that most of the "factor" outperformance research has been debunked, being mostly liquidity related. In the end, it doesn't matter all that much WHY it works. Just avoid cap weight in all your investing. (and never use an "at market" order!)
Equal weight beat cap weight "only" about 70% of rolling-five-year periods since 1916 on the S&P 500 and its cap weight predecessors, and the average amount across all those five year periods was quite large.
Jim
